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The New Zealand tech sector remains buoyant, with an explosion of merger and acquisition activity – increasing from $750m to $11b per year over the past 15 years, according to a recent report*. Tech firms looking to be acquired by offshore purchasers will often be presented with term sheets offering an attractive headline purchase price, with negotiation then leading to signature and an exclusivity period before legal and financial advice is engaged.
Often this is a mistake.
Although frequently expressed to be non-binding, the content of term sheets can dictate the future course of a transaction, particularly with respect to value. It’s therefore critical to ensure that value isn’t inadvertently lost through a disparity of advice and transaction experience between seller and buyer at the term sheet stage.
From a seller’s perspective, value can be lost in a variety of ways. We consider several key areas, below.
Properly value tax assets
Tax assets, such as losses, should be taken into account when assessing purchase price. Owing to recent tax law changes, losses are no longer necessarily lost upon a change of control, as used to be the case. Depending on the tax-paying status of the company, accumulated losses can have real value.
Tech firms also frequently issue options to key employees. The firm will often be entitled to a tax deduction when those options are exercised, as will typically be the case when a change of control transaction occurs. The value of this deduction can be significant, again depending on the tax paying status of the company, and again should be considered when assessing purchase price.
Joshua Pringle explains this in more detail in our latest podcast from 01:45
Consider transaction structure
At a high level, transactions can be structured as a sale of shares or a sale of assets.
Asset structures may be preferred by offshore purchasers, particularly where significant IP assets are in play.
Transaction structure can have significant value implications for sellers and the consequences of a purchaser’s preferred structure should be considered when assessing value. Often these consequences won’t be obvious, and specialist advice will be needed to determine the value implications of a particular structure.
Joshua Pringle explains this in more detail in our latest podcast from 02:45
Secure sufficient safeguards for earn-outs
Earn-outs (additional purchase price payable if the target company achieves future financial targets) are increasing in popularity, and can allow buyers and sellers to bridge valuation gaps.
Earn-outs are attractive in principle but complex in practice, with a tension between the buyer’s ability to run the company as it sees fit competing with a seller’s interest in best ensuring the company meets the earn-out targets. Sellers should pay particular attention to ensuring the earn-out mechanism recognises this tension and properly protects the seller’s interests.
Joshua Pringle explains this in more detail in our latest podcast from 03:50
Prospective buyers will typically be keen to secure an exclusivity period before committing to due diligence and comprehensive negotiations. While agreeing to a period of exclusivity may be necessary, sellers shouldn’t agree to exclusivity without considering its implications for value.
Depending on the situation, it may be that a formal auction process, where exclusivity is granted only following the submission of bids from multiple parties, could result in a better financial outcome. Alternatively, a company that is the subject of interest from multiple prospective purchasers could use the prospect of an early grant of exclusivity to leverage a higher purchase price from an enthusiastic bidder.
Joshua Pringle explains this in more detail in our latest podcast from 05:10
Consider the purchase price adjustment
Purchase price adjustments typically take either a net working capital (purchase price is adjusted by comparing actual net working capital delivered on completion with a normalised target) or locked box (purchase price is set by reference to specific historic financial statements) approach. Both mechanisms can be complex and allow opportunities for sophisticated parties to take value.
If a term sheet deals with the specifics of a purchase price adjustment, a seller should take specialist advice to ensure no unexpected value transfer will occur.
Joshua Pringle explains this in more detail in our latest podcast from 06:40
Consider Warranty & Indemnity Insurance
Warranty and indemnity insurance is a product sold by specialist insurers which, in the absence of fraud, puts the responsibility for paying out on warranty and indemnity claims on the insurer, allowing sellers a clean exit. The cost of this product has been increasing recently, owing to massive demand.
Sellers may be best placed at the term sheet stage, and particularly before any grant of exclusivity, to agree with a prospective buyer that the transaction will be insured, and to negotiate the parties’ relative contributions to the cost of that insurance. Raising the idea of warranty and indemnity insurance after the term sheet has already been signed can be too late, particularly if the term sheet already addresses warranty and indemnity issues.
Joshua Pringle explains this in more detail in our latest podcast from 08:15
In short, getting the term sheet right is critical to getting the most value out of a transaction. Taking specialist legal and financial advice at the term sheet stage is money well spent.Josh Pringle, partner
*A report by Clare Capital for Callaghan Innovation